Our Opinion: 2018

Turkey’s crisis could have huge repercussions

Turkey is not a significant player in the global economy but, if it reneges on its debt, there could be huge repercussions for the rest of us.

With an overheating economy and fast-rising inflation, Turkey was an accident waiting to happen. The catalyst came when President Recep Tayyip Erdogan stopped the central bank raising interest rates; higher rates were needed to stabilise the lira.

This was followed by a spat with the US over Andrew Brunson, an imprisoned American evangelist, which has resulted in sanctions being placed on two Turkish politicians. For a less vulnerable economy, this would not have mattered. But for Turkey, it appears to have been the last straw. With investors fretting over Erdogan’s unwillingness to allow the central bank to take action to stem inflation, plus the threat of an escalating battle with a Trump-led US, the lira lost all support. It has now worth 40% less against the US Dollar than a year ago.

Turkey is facing recession, inflation and, probably, worsening political repression too. In economic and investment terms, however, the country is tiny. It accounts for about 1% of the global economy, and it doesn’t do a huge amount of trade except with its neighbours. The Turkish stock-market is also internationally insignificant. The UK stock-market alone is 50 times as big, and only 20% of Turkish stocks are owned by non-residents.

As for the banking system, some eurozone banks have exposure to Turkey: Spain’s BBVA has a big stake in Turkey’s second-biggest private bank, and the French and Italian banks are next, but they don’t have huge exposure (and the UK has very little). So, assuming a normal course of events, any spillover in terms of rising bad debts shouldn’t cripple the financial system.

One problem is that what’s happening in Turkey is just a symptom of a wider malaise. Turkey is being hit hardest because it’s vulnerable (which in turn is due to bad and deteriorating governance). We’ve seen this panic before. In May 2013 the Federal Reserve in the US signalled that it would begin the process of ‘tapering’ quantitative easing (QE), buying fewer and fewer bonds as the months went by, until the Fed had stopped injecting new money into markets altogether.

The market panicked, understandably given the impact QE had on the way up. The first markets to feel the pain were those emerging-market countries with high deficits. The main problem with a high current-account deficit is that it means you are reliant on foreign money to prop up your economy. This foreign money is often fickle. So, if you are an investor in one of these countries, it makes sense to panic first and ask questions later.

As a result, Turkey, Brazil, Indonesia, India and South Africa (the ‘fragile five’, as they were nicknamed) have all seen their currencies slide against the US dollar. The same is happening today – fears about Turkey have infected the same group of countries. We’ve also seen jitters elsewhere. Italian government debt is showing signs of stress – it’s become more expensive for Italy’s government to borrow money, particularly relative to a ‘safe’ country such as Germany. In short, investors are becoming more risk-averse as global monetary policy tightens.

Turkey might be able to repay its debts (at the price of bearing some economic pain) – but will it choose to do so? In a world of discount rates and cash flows, the ability to pay and the willingness to pay are the same thing… Yet history is littered with numerous examples of those who could pay but have chosen not to, simply because the political and social cost is too high. And Turkey might well fall into the latter category, particularly given Erdogan’s attitude towards foreign investors.

For a country with large foreign-currency debt, a mass sale of local assets to foreigners or a crushing recession delivering a major current-account surplus are the only ways to repay excessive levels of such debt. These two options are rarely compatible with re-election for politicians and are seen by the populace as sacrificing local livelihoods for the benefit of foreign financial predators.

As a result, Turkey could impose capital controls, which in turn could result in an effective default on around $500bn of credit assets held by the global financial system. This would almost certainly be the largest emerging-market default of all time.

In turn, this would force investors to price in a major new risk to emerging markets across the globe, particularly those with large levels of foreign-denominated debt. A major and rapid re-evaluation of emerging-market risk is now on the cards with negative impacts for exchange rates and asset prices and, ultimately, through a higher cost of capital, global growth.

Can this be avoided? It’s now in the realm of politics. a move to release Brunson would at least signal Erdogan is willing to make concessions which could aid the currency. Right now, that doesn’t seem very likely.

2nd October 2018